What is Inflation? Inflation is rising general level of prices

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1 What is Inflation? Inflation is rising general level of pricesInflation reduces the “purchasing power” of moneyExamples:It takes $2 to buy what $1 bought in 1982It takes $6 to buy what $1 bought in 1961When inflation occurs, each dollar of income will buy fewer goods than before.

2 How is Inflation measured?The government tracks the prices of the same goods and services each year.This “market basket” is made up of about 300 commonly purchased goodsThe Inflation Rate-% change in prices in 1 yearThey also compare changes in prices to a given base year (usually 1982)Prices of subsequent years are then expressed as a percentage of the base yearExamples:2005 inflation rate was 3.4%U.S. prices have increase 98.3% since 1982 (base year).The inflation rate in Bolivia in 1985 was 50,000%This is called HyperinflationA $25 meal today would cost $12,525 a year later

4 Make a T-Chart Hurt by Inflation Helped by InflationLenders-People who lend money (at fixed interest rates)People with fixed incomesSaversBorrowers-People who borrow moneyA business where the price of the product increases faster than the price of resourcesCost-of-Living-Adjustment (COLA)Some works have salaries that mirror inflation.They negotiated wages that rise with inflation

6 Consumer Price Index (CPI)The most commonly used measurement inflation for consumers is the Consumer Price IndexHere is how it works:The base year is given an index of 100To compare, each year is given an index # as well=Price of marketbasket in base yearx 100CPIPrice of market basketMarket Basket: Movie is $6 & Pizza is $14Total = $20 (Index of Base Year = 100)Market Basket: Movie is $8 & Pizza is $17Total = $25 (Index of )125This means inflation increased 25% b/w ’97 & ‘09Items that cost $100 in ’97 cost $125 in ‘09

8 Problems with the CPISubstitution Bias- As prices increase for the fixed market basket, consumers buy less of these products and more substitutes that may not be part of the market basket. (Result: CPI may be higher than what consumers are really paying)New Products- The CPI market basket may not include the newest consumer products. (Result: CPI measures prices but not the increase in choices)Product Quality- The CPI ignores both improvements and decline in product quality. (Result: CPI may suggest that prices stay the same though the economic well being has improved significantly)

10 CPI/ GDP Deflator (Year 1 as Base Year) Make year one the base yearCalculating CPICPI/ GDP Deflator (Year 1 as Base Year)Nominal,GDPInflation RateReal,GDPPricePer UnitUnits ofOutputYear1234510152025$ 45684Make year one the base year=Price of the same marketbasket in base yearx 100CPIPrice of market basket in the particular year

12 Make year three the base yearPracticeNominal,GDPReal,GDPConsumer Price Index(Year 3 as Base Year)Units ofOutputPricePer UnitYear12345510204050$ 68101214$3080200480700$501002004005006080100120140Make year three the base year=Price of the same marketbasket in base yearx 100CPIPrice of market basket in the particular year

13 CPI vs. GDP DeflatorThe GDP deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers.An increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI.The GDP deflator includes only those goods and services produced domestically. Imported goods are not a part of GDP and therefore don’t show up in the GDP deflator.=Real GDPx 100GDPDeflatorNominal GDPIf the nominal GDP in ’09 was 25 and the real GDP (compared to a base year) was 20 how much is the GDP Deflator?